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Note Buyer – The Case for Bigger down payments

Following the financial fiasco and real estate meltdown of the last few years, an additional sad part of the whole affair has been the reaction of the U.S. government. Instead of recognizing what got us into this mess and fixing the root cause, they have only made things worse with ill-conceived programs and band-aid fixes.

Many people who could not afford to buy a house were able to do so only because bankers got so greedy that they let poor credit-risk customers use inappropriate programs like interest-only loans and option ARMs. They added on to the problem by waiving other criteria that should have kept these homebuyers as renters until they had the financial ability to truly afford a home. Many of these buyers could afford no more than a token down payment, which should have been another red flag to keep them out of the system.

Banks offered house loans with no down payment requirement and FHA (Federal Housing Administration) required only a 3% down payment. Banks have now realized the fallacy of their ways and stiffened down payment requirements. The FHA, on the other hand, raised their down payment requirement from a piddling 3% to an only slightly less anemic 3.5%. As a note buyer, I am appalled at the way FHA offers loans.

Logically, a home buyer who puts in a reasonably large down payment (e.g. 10% or more) is less likely to default than a buyer who has put in little or nothing. This was proven in a study by Felix Salmon and the writer of the Dr. Housing Bubble blog. They found that , when there was equity of 30% or more in a home, the default rate was only 1.9%. At the other end of the scale, those with less than 5% equity had a default rate of about 16% — more than eight times higher. Between the 5% and 30% equity amounts was a line clearly showing the correlation between large down payments and low default rates. When people have put in their own money and have “skin in the game”, they will naturally try much harder to avoid defaulting. A note buyer like myself always prefers to have plenty of equity in the property to protect our position.

Because of FHA’s 3.5 down payment minimum, which is the lowest game in town, FHA loans have climbed to account for nearly 20% of all loans on single family homes (source: The Congressional Budget Office). This percentage is much higher than in the past and an order of magnitude larger than ever intended. To the bureaucratic mind, it is a good thing to have more people qualify to buy houses now. To a thinking person who isn’t concerned about the next election, this is a recipe for disaster. Many of these new buyers (16% perhaps?) will default, which just pushes the problem into the future.

Even when owner financing is used and the note holder plans to sell the mortgage note to a note buyer, there is rarely a time when a down payment of less than 10% is justified. Yes, requiring a 10% plus down payment will mean less house sales now, but it will create a much more stable housing market long-term and prevent using taxpayer funds to come to the rescue all over again.